Sale to a Grantor Trust

Irrevocable trusts are easily one of the most common tools in any quality Wealth Advisory plan. But planners also use a variation on a typical irrevocable trust: a Defective Irrevocable Grantor Trust (DIGIT). This trust allows for additional flexibility by taking advantage of the “Grantor Trust” rules. In essence, those rules state that the grantor (client) is the owner of the trust for income tax purposes, but otherwise the assets in the DIGIT are out of the client’s estate.

This tax provision allows the client to personally pay the taxes on trust income making it effectively a tax free gift to the trust. Otherwise, the trust would pay its own taxes, at the exorbitantly high trust tax rates, reducing the value of the trust assets.

But where the DIGIT holds its biggest appeal is in its estate freezing capability. In this situation, the client sells appreciating (and preferably income producing) assets to the trust for a stated amount. A big advantage here is that valuation discounts are often allowed by appraisers due to lack of marketability and minority interest reasons on these assets. This will allow for the sale at less than fair market. In return for the sale, the trust enters into a loan agreement with the client, most often an interest-only note for a specific term of years. Generally, the assets sold to the DIGIT are income producing assets so that there is sufficient income to pay the interest on the loan. This loan interest is NON-taxable to the client since the trust and client are deemed to be one and the same for income tax purposes.

So the client has effectively moved not only the asset, but the growth on the asset out of his estate. And unlike a GRAT, the client does not need to outlive the term of the trust to keep the asset out of the estate. Furthermore, unlike a GRAT a DIGIT can be designed with Dynasty Trust language so that the DIGIT can become a multi-generation trust providing benefits for many years to come.

And it’s often for those reasons, many planners use life insurance in the DIGIT to address the impending estate tax liquidity issue. Because the assets in the DIGIT are income producing, there often is sufficient enough income each year to pay for the insurance-all the while without gift tax. This method of paying for the insurance is extremely effective and quite popular, especially considering the alternative: the traditional method of gifting insurance premiums to an ILIT & possibly incurring gift tax.

Sales to a DIGIT are probably most effective for clients who are unable or unwilling to make annual exclusion gifts or have already used their applicable gift exclusions of $5,600,000. The sale to a DIGIT allows a client to move large amounts of assets out of their estate with virtually no gift tax implications. By doing so, they have reduced their taxable estate and subsequent estate tax burden. But they may still enjoy the benefits of these income producing assets via the loan repayment and the non-taxable payments back to the client.